The Consequences of Concentration in Private Equity

One of the interesting features of a robust Private Equity marketplace has been the ever increasing amounts of capital raised for the purpose of investing in privately held firms. Money is increasingly flowing to a select group of big brand name firms who can seemingly raise money at will. The 10 largest private equity funds closed in 2014 accounted for 19% of overall fundraising for that year. By 2016, that had risen to 26%.

It’s a trend that looks likely to continue in the coming year. More and more money is flowing to a relatively few big brand names. In essence, private equity is increasingly coming to look like other parts of the investment industry, with a bifurcation in the market: a few behemoths dominating with a lot of regional boutiques making up the rest of the market.

That outcome is driven largely by the institutional investor market in private equity, including pension funds and sovereign wealth funds, and their consultants. Advisers recommending the well-known names are less likely to find themselves second guessed by their client’s investment committee than those selecting smaller emerging private equity managers. The concentration of capital is therefore, perhaps, inevitable. But it isn’t without consequence.

One of the consequences is that more money hence larger individual investments, need to be deployed in a world of finite opportunity - unicorns notwithstanding. To begin with, it should be obvious that the term “private equity” has now long been a misnomer. Public offerings for private equity firms have changed the landscape and the description of the discipline.

At the same time, the concentration of capital undermines one of the arguments for taking these private equity firms public: Namely, that doing so helped to “democratize” private equity. This was not just about making private equity available to a greater range of investors; it was also that the increase in assets would boost the breadth and depth of funding available in an evergreen vehicle across a wide range of private equity funds. Has this promise been kept or has it merely led to larger deal sizes and higher multiples being paid (more on this thought in a moment.) These private equity funds would deploy capital targeting different objectives and providing funding within all stages of companies’ development and maturity. Just as the public equity market has recently enjoyed a momentum built on technical elements (deep supply of capital) the private equity market will face similar market values borne of technical demand/supply patterns. Multiples paid for transactions have continued to increase year over year and a portion of this result has to be owing to greater amounts of capital pursuing a finite number of quality investments.

So does this amount of increased capital naturally deliver results that are reverting to the mean return that mirrors public equity returns? In fairness, in 2017 the S&P returned 24% and the argument to PE investors has been that on average private equity funds would outperform the public market by 6 – 8% over the life of the fund. This comparison is a difficult one when reliant upon higher multiples of cash flow being paid for companies in the current private equity market. Also, the recent tax law changes discourage heavy leverage through the imposition of a cap on the deductibility of interest on corporate debt which could impact returns for buyout focused private equity funds. Thus more capital paying higher prices on average while compared to a frothy public equity market makes return comparisons difficult between the two asset classes.

Now private equity returns are not normally measured in one year increments but the performance of the private equity funds in recent time would still need to be at least a 20% - 25% IRR net of fees and expenses, over a 3 – 5 year time period to return the size of premium which enables it to be superior to recent public equity market returns. The larger size of a fund may not necessarily correlate to this type of outcome.

None of this is to argue that the big funds don’t serve investors very well. They still have to perform in order to retain popularity with institutional investors. But, notwithstanding venture capital investment in developing “unicorns”, we are seeing private equity funds with a need to employ greater amounts of capital potentially become similar to other public equity investments.

The large asset gatherers in the financial services industry have usually been commonly associated with the public equity and debt markets. The private equity industry has been institutionalized and is now essentially resembling the merchant banks of yesteryear, except they are SEC regulated now. Whether for good or ill, the concentration of capital may have consequences for private equity’s role, its future – and its regulation. Will the SEC continue, for instance, to focus its efforts on retail investors in smaller funds (see Rosemary Fanelli’s article on page __), even as large sums of institutional money increasingly concentrates ever more strongly in larger funds?

The implications from this trend for all market participants including sponsors, limited partners, and the businesses they fund are varied and many. The promise of private equity sponsored companies was that they were more strategically flexible and more efficient in instituting change as needed. Also that they did not have the quarterly pressure of a public shareholder group to worry about in their planning. Now that some of these funds are housed in publicly traded vehicles does that mean that they will turn more short term in their strategic thinking for their private equity holdings (for example doing a leveraged dividend versus redeploying that money into company capital expenditures?) in order to deliver quarterly results to their own public shareholders?

This type of push/pull in private equity firm decision making requires both a short and long term philosophy for each of their investments. Historically, they were concerned with the long term benefits primarily of their strategic direction – has it been compromised in their new public persona?

Some may argue that infusing artificial intelligence into the equation for selecting private equity managers might reveal the flaws and the benefits of the current selection process. Maybe investment advisors of the future will employ such technologies and techniques to ensure better outcomes.

The trend line, however, is obvious as more money enters into an asset class it risks the conversion to a commoditized asset. Has private equity begun to go in that direction? It is already arguable if not probable.

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